Financial institutions like banks or insurance companies are financial intermediaries. That is, they act as go-betweens for two parties with different needs, so that those two parties do not have to seek each other out. Banks connect savers with borrowers, and I gave a fairly detailed discussion of that in the other post. Here, I will focus on insurance companies.

There are two main types of insurance companies.

Life insurers, who pay out an agreed sum to beneficiaries at the time of the policy holder's death; and

property and casualty insurers, which cover unforeseen damage to assets such as cars, homes, or businesses.

In both cases, the insurance company charges a fee known as a premium in exchange for bearing the associated risk. The buyer of the policy thus transfers a specific risk (such as leaving his family destitute or the financial loss resulting from a car accident) to the insurer. Investors in the insurance company ultimately bear the financial risk, while the company manages the business aspects such as soliciting policyholders and collecting premiums.

In addition to basic business management skills, insurance companies must employ people who understand risks uniquely associated with the insurance business. Predominant among these are fraud, moral hazard, and adverse selection. Only if these risks are successfully mitigated can the insurance company truly serve its constituencies.

Fraud refers to claims that would not be covered under the contractual agreement. For example, a homeowner may have stained carpets that she does not want to replace. However, after a storm causes damage to the roof she claims that the resulting water damage caused the stains and has them replaced. The premium charged by the insurance company is not calculated to cover normal wear and tear, but only unusual damage. Fraudulent claims harm not only insurance company investors, but also other policyholders as the insurance company charges higher premiums than it otherwise would to offset this risk.

Moral hazard is when people who have insurance act recklessly as a result of having offset their financial risk. For example, an uninsured driver may be more likely to lock his car to prevent it from being stolen.

Finally, adverse selection is the tendency for insurance to be purchased only by those likely to need it. If all thirty-year-olds bought life insurance the premiums would be very cheap, as any individual that age is unlikely to die and the risks would be spread among many policyholders. However, most thirty-year-olds know they are unlikely to die and are therefore unwilling to pay even a small premium for that insurance. However, a thirty-year-old who works in a dangerous profession or has a fatal illness would certainly want insurance. Since only those who are more likely to need the insurance are inclined to purchase it, the risk to the insurer is both higher and is spread among fewer policyholders. Both of these factors result in higher premiums to offset the risk.

If you are interested in a career in a financial institution and found this article helpful, you might be interested in the CFA Institute Investment Foundations program. The curriculum is available free of charge, and if desired you can demonstrate your mastery by registering for the exam.